Best active bond funds for your Isa

What kind of bond funds you hold is dependent on your attitude to risk and outlook. "The high yield and therefore riskier areas of the market are looking more expensive," says Adrian Lowcock, senior investment manager at Hargreaves Lansdown. "Yields are lower so you are not being compensated for the risk you are taking. Yields on gilts have come off their lows and have started to settle at around 2.7 per cent and look reasonable. But longer-term interest rates might rise and this could cause gilt prices to fall further, so investors need to be careful.

"Corporate bonds are also offering low yields. So overall the best fixed income fund to be in is one which can go anywhere and of which the management team delivers over the medium and longer term. Therefore, a strategic bond fund would be my favoured suggestion. The managers can invest anywhere in the market and exploit opportunities wherever they arise, but also move to parts of the markets as circumstances and the economic outlook changes."

Strategic bond funds have been the preference for many advisers over the last few years (read more on this). These can move in and out of different fixed income asset classes and, perhaps more importantly, steer clear of risky areas.

Choosing which different type of bond funds to allocate to, and in what proportions, whether government, high yield or corporate is generally more difficult than choosing equity funds because so much macroeconomic research is needed. Private investors cannot necessarily access all the different types of fixed income available via a single sector bond, for example, mortgage and asset-backed securities. But a strategic bond fund is like a one-stop shop: the investment team, which will encompass tens or hundreds of people, including an economist and various types of analysts, research and make the allocation for you, as well as constantly monitoring and moving it around when appropriate.

This is particularly useful for investors with smaller portfolios, such as Isas in the early stages which do not yet have enough assets to allocate across various funds. One strategic bond fund can give you a good spread of what are hopefully the better areas of fixed income.

"A year ago there was little to be said for investing in bond markets, as prices had been artificially propped up by central banks buying them to keep borrowing costs down and, consequently, yields were squeezed," says Jason Hollands, managing director at Bestinvest. "However, the markets are moving on and the US Federal Reserve is now gradually reducing its bond-buying activities. The market is on a path to normality and yields have risen. That adjustment process has yet to fully play out, so we think the best way to access the bond markets is still through funds where the managers have considerable flexibility to adapt their positioning - strategic bond funds."

Fixed income funds have what is known as interest rate or duration risk, and many investment professionals are of the view that a short duration is important at present. When interest rates rise, the capital value of existing bonds falls, with the extent of the fall depending on the duration of the bond, which is principally dependent on the future maturity date of the bond and the size of its coupon.

"As a rough rule of thumb, when interest rates rise by 1 per cent the capital value of the bond will fall by 1 per cent for each year of duration, so the longer the duration the greater the fall," explains Robert Pemberton, investment director at HFM Columbus Asset Management. "For example, a bond with a duration of two years will only fall by only around 2 per cent, but a long duration bond of 15 years could fall by up to 15 per cent. Long-duration bonds, which are far more sensitive to interest rate movements and where the risk of capital loss is substantially greater, should continue to be avoided."

And strategic bond funds are particularly useful for managing interest rate risk via their ability to change duration.

Risk

However, because strategic bond funds can change their risk profile over a very short time period, they are unsuitable for investors with a low-risk appetite. For example, they could have a large proportion of their assets in high-yield bonds.

"The main risk is getting the asset allocation decisions wrong, for example, buying gilts when you should be selling them," adds Mr Lowcock. "This can easily lead to capital loss which could have a huge impact on the long-term performance of a fund. The income yield from some of these funds can be volatile as managers might target total return over income generation, an example being Invesco Perpetual Tactical Bond (GB00B4V7X088)."

If a substantial portion of your portfolio, for example around 40 per cent or more, is allocated to fixed income, you could split the allocation between three or four strategic bond funds. This can be particularly relevant because, while these funds are categorised together in the Investment Management Association (IMA) Sterling Strategic Bond sector, they do things quite differently to each other. For this reason, before you invest in one it is very important you check the fund literature to see what it does, what its current allocation is and what it could potentially invest in going ahead.

"Don't chase yield - this is likely to indicate higher risk," adds Mr Lowcock. "And the opposite is not necessarily true - that a low yield will be low risk - so look under the bonnet."

Recommended bond funds

For a strategic bond fund to do well its manager needs to make the right decisions so when choosing one it is a good idea to go for an experienced manager with a good record, says Darius McDermott, managing director at Chelsea Financial Services.

He likes four funds with experienced managers which we also include in our IC Top 100 Funds. These are Legal & General Dynamic Bond Trust (GB00B1TWMM97), whose manager Richard Hodges is experienced in using derivatives, Jupiter Strategic Bond (GB00B2RBCS16) and M&G Optimal Income (GB00B7FM9R94). Henderson Strategic Bond (GB0007495293), meanwhile, has one of the highest yields in the Sterling Strategic Bond fund sector, at 5.85 per cent.

Andrew Johnston, fund analyst at Brewin Dolphin, likes Henderson Preference & Bond (GB0007535866), a strategic bond fund run by the same managers as Henderson Strategic Bond, but which yields 6.04 per cent because it is focused on the production of income.

"The managers' excellent long-term track record gives us confidence that the fund will continue to deliver a high level of income while balancing the risks to investors," says Mr Johnston.

Mr Lowcock suggests Morgan Stanley Sterling Corporate Bond (GB0032487554), which yields 3.36 per cent, as a non strategic bond fund option for low risk investors. "The fund is run by an experienced team managing a very small amount of money," he says. "They have the analytical support to do the credit analysis to ensure they are not caught out and have as good a chance as anyone at making the right calls. Their record suggests they can add and take away risk at the right times."

For medium risk investors, Mr Lowcock suggests Invesco Perpetual Tactical Bond (GB00B4V7X088), a strategic bond fund which yields 3.05 per cent. "Investors should be aware that the managers look to run this fund on a total return basis and are not targeting a specific income yield," says Mr Lowcock. "Therefore, the yield could be quite volatile. With a strong management team in place (bond veterans Paul Read and Paul Causer) investors who are happy to take a bit more risk should benefit from a very actively managed fund."

For medium risk investors, Ben Gutteridge, head of fund management at Brewin Dolphin, suggests TwentyFour Monument Bond Fund (GB00B3VH8400) which yields 2.72 per cent. "This fund invests in high quality residential mortgage-backed securities (RMBS)," he says. "Such investments conjure up fears of the US subprime crisis, however, those assets are on a different risk plane to those that TwentyFour invests in. It only buys RMBS with much lower loan-to-value ratios. These investments are much higher quality and can suffer a significant degree of house price depreciation before they become vulnerable. Given the floating rate nature of many of the loans, they are also a good hedge against a rising interest rate environment."

Another non-strategic bond fund option for medium-risk investors is M&G Global Macro Bond Fund (GB0031960254), which carries a lower liquidity risk than other strategic bond funds because it invests in sovereign markets and currencies. "It has a low correlation to equities but carries significant currency risk," says David Coombs head of multi-asset investments at Rathbone Unit Trust Management.

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For high-risk investors, Mr Lowcock suggests Royal London Sterling Extra Yield Bond Fund (IE0032571592) which yields 6.15 per cent. "This is a high octane strategic bond fund," says Mr Lowcock. "The manager aims to identify the sweet spot in terms of risk versus return and identify these value situations within the bond universe he is looking at. Given the aggressive nature of this fund, the capital could be at risk if bond yields started to rise."

Mr McDermott suggests Invesco Perpetual Monthly Income Plus (GB0033051334) as a higher risk strategic bond fund option. This has nearly 20 per cent of its assets in equities run by Ciaran Mallon since last October (Neil Woodford used to run this). Paul Read and Paul Causer run the fixed income section. The fund aims for both a high level of income and capital growth over the medium to long term.

Mr Gutteridge suggests Invesco Perpetual Global Financial Capital Fund (GB00B3ZZ0997), which invests across the capital structure in the financial sector, including senior bonds, subordinated debt and even some equity.

"There are a number of variables that should allow this fund to deliver next year," he says. "If longer-dated interest rates are rising due to better economic growth, the asset quality of financials' balance sheets should also improve. Furthermore, the improved margin from making additional loans while deposit rates remain firmly anchored will be earnings-enhancing."

Performance of recommended bond funds

Source: Morningstar

Performance data as at as at 21 February 2014